Investors eye the 'cliff' as Obama gains in polls

President Barack Obama waves as he boards Air Force One at Andrews Air Force Base, Md., Sunday, Sept. 30, 2012. Obama is traveling to Las Vegas for a campaign rally then will be staying in Nevada to prepare for the first presidential debate with Republican rival, former Massachusetts Gov. Mitt Romney, on Wednesday, Oct. 3, 2012.
Photo by The Associated Press.

NEW YORK (AP) — As President Barack Obama widened his lead over Mitt Romney in polls this month, traders at hedge funds and investment firms began shooting emails to clients with a similar theme: It's time to start preparing for an Obama victory.

What many in the market worry about isn't that high earners may pay more in taxes if Obama wins. They worry that federal spending cuts and tax hikes scheduled for 2013 will kick in on Jan. 1 and start pulling the country into another recession. The higher taxes and lower spending would total $600 billion. They take effect automatically unless Congress and the White House reach a deal before then.

If he's re-elected, Obama will still face a House of Representatives controlled by Republicans the rest of the year. And the new Congress that takes office in January may have a Republican House, too. Investors says that's likely to set up a budget battle similar to August of last year, which ended with the country losing its top credit rating and panicked investors fleeing the stock market.

"If you have any kind of gridlock, you run the risk of inaction," says Tom Simons, a market economist at the investment bank Jefferies. "This is a situation where inaction is the worst outcome."

Obama and others like former President Bill Clinton have expressed the belief that House Republicans could be more cooperative once the election is over.

"They'll be faced with determining whether we get a recession or not," says Jeff Kleintop, chief market strategist at LPL Financial.

Most on Wall Street think Congress and Obama would eventually manage to at least postpone some of impending tax and spending changes before this year is out.

The Congressional Budget Office recently laid out the grim consequences of such an event — often compared to dropping off a "fiscal cliff." Starting Jan. 1, tax cuts signed by President George W. Bush expire as do Obama's cuts to payroll taxes. Federal spending on defense and other domestic programs will drop, while emergency unemployment benefits run out.

The combined effect off all these changes would shrink the economy nearly 3 percent at an annual rate in the first half of next year, the CBO estimates, and push unemployment up to 9.1 percent by the fall. The unemployment rate was 8.1 percent in August. Recent surveys of businesses suggest the threat is already weighing on the minds of executives when they're making hiring and spending plans.

For the world's biggest money managers, the fiscal cliff now ranks as the greatest hazard to the global economy, according to Bank of America's most recent fund manager survey. It topped the European debt crisis, a collapse in Chinese real estate and even a war between Israel and Iran.

The danger looms so large to most investors that they believe Washington will find a way to escape it.

"Ultimately, I think a deal gets done, but it's just a question of how long it takes to get there," Kleintop says. "By no means is it going to be an easy process. Gridlock means there's a greater chance that this drags on into next year."

Analysts at investment firms have kept a close eye on polling numbers and especially on the Intrade, an online marketplace where members can trade predictions on events like elections. Polls show voters leaning toward Obama in key swing states. On Intrade, the odds have swung strongly in Obama's direction, jumping to a 76 percent chance of re-election, up from 51 percent at the start of September.

Intrade markets put the chance that Republicans will retain control the House at 74 percent.

If these forecasts prove right, the balance of power in Washington would remain the same. Democrats keep the White House and a slim majority in the Senate, and Republicans keep the House.

What troubles investors is that the same elected officials who fought over raising the debt ceiling last year could be taking up the same task again while debating how best to maneuver around the fiscal cliff. Treasury officials have estimated that Congress won't have to raise the debt limit until January.

Expect to see a replay of the debt-ceiling fight, says Ian Lyngen, a senior government bond strategist at CRT Capital. Except that this time what's at stake is the country's borrowing limit and a recession.

"I'm sure it's going to go just like it did last time — very messy," Lyngen says.

In one dizzying stretch that August, the Dow Jones industrial average dropped 2,000 points in three weeks.

"And don't forget," Lyngen adds, "that ultimately got resolved."

The widespread belief on Wall Street is that Congress and Obama will start negotiations over raising the debt limit and pushing back the fiscal cliff when they return in late November — the so-called lame-duck session, because newly elected members of Congress will not have taken their seats.

Twists in the talks will likely rattle markets as the new year approaches. But if stocks do fall sharply, investors expect that would push Republicans and Democrats to reach a deal.

"Ugly negotiations in the lame-duck session could really throw the market for a loop," says Kleintop. "It could be a painful process for investors."

In a report out this week, analysts at Goldman Sachs tried to estimate just how painful could be. Goldman expects the stock market will start sinking after the elections as people realize the fiscal cliff "will not be solved in a smooth fashion."

That's the reason Goldman forecasts that one broad measure of the stock market, the Standard & Poor's 500 index, will end this year at 1,250 — a 13 percent drop from where it closed Friday.

Beyond that it gets worse with no deal. The $600 billion in cuts and tax hikes kick in and experts say a recession would be likely. That's also why some take solace in the idea that, whatever their political party, nobody wants the economy to shrink.

Dan Greenhaus, chief global strategist at the brokerage BTIG, wonders if that's placing too much faith in Washington. "Republicans aren't losing the House," Greenhaus said. "So as the odds of Obama winning re-election go up, what you have to ask is: How are these two parties going to find middle ground in just a few months? I have no idea."